Profit Margin Hedging

Some extension economists and others often recommend profit margin hedging in choosing the timing of crop sales. This paper determines producer’s utility function and price processes where profit margin hedging is optimal. Profit margin hedging is shown to be an optimal strategy under a highly restricted target utility function even in an efficient market. Although profit margin hedging is not the optimal rule in the presence of mean reversion, it can still be profitable if prices are mean reverting. Simulations are also conducted to compare the expected utility of profit margin hedging strategy with the expected utility of other strategy such as always hedging and selling at harvest strategies. A variance ratio test is conducted to test for the existence of mean reversion in agricultural futures prices process. The simulation results show that the expected utility of profit margin hedging strategy is highest. The paired difference tests for the profit margin hedging and other two strategies shows that the expected utilities of profit margin hedging strategies are not significantly different from those of always hedging strategy, but are significantly different from those of selling at harvest strategy except when the transaction cost is considered. The results of variance ratio test indicate that there is little evidence that futures price of wheat follows mean reverting process.